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Behavioral economics
Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. The fields are primarily concerned with the rationality, or lack thereof, of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral analyses are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases. History During the classical period, economics had a close link with psychology. For example, Adam Smith wrote an important text describing psychological principles of individual behavior, The Theory of Moral Sentiments and Jeremy Bentham wrote extensively on the psychological underpinnings of utility. Economists began to distance themselves from psychology during the development of neo-classical economics as they sought to reshape the discipline as a natural science, with explanations of economic behavior deduced from assumptions about the nature of economic agents. The concept of homo economicus was developed and the psychology of this entity was fundamentally rational. Nevertheless, psychological explanations continued to inform the analysis of many important figures in the development of neo-classical economics such as Francis Edgeworth, Vilfredo Pareto, Irving Fisher and John Maynard Keynes. Psychology had largely disappeared from economic discussions by the mid 20th century. A number of factors contributed to the resurgence of its use and the development of behavioral economics. Expected utility and discounted utility models began to gain wide acceptance which generated testable hypotheses about decision making under uncertainty and intertemporal consumption respectively, and a number of observed and repeatable anomalies challenged these hypotheses. Furthermore, during the 1960s cognitive psychology began to describe the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field such as Ward Edwards, Amos Tversky and Daniel Kahneman began to benchmark their cognitive models of decision making under risk and uncertainty against economic models of rational behavior. Perhaps the most important paper in the development of the behavioral finance and economics fields was written by Kahneman and Tversky in 1979. This paper, 'Prospect theory: Decision Making Under Risk', used cognitive psychological techniques to explain a number of documented anomalies in rational economic decision making. Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago (see Hogarth & Reder, 1987), a special 1997 edition of the respected Quarterly Journal of Economics ('In Memory of Amos Tversky') devoted to the topic of behavioral economics and the award of the Nobel prize to Daniel Kahneman in 2002 'for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty. Prospect theory is an example of generalized expected utility theory. Although not commonly included in discussions of the field of behavioral economics, generalized expected utility theory is similarly motivated by concerns about the descriptive inaccuracy of expected utility theory. Behavioral economics has also been applied to problems of intertemporal choice. The most prominent idea is that of hyperbolic discounting, in which a high rate of discount is used between the present and the near future, and a lower rate between the near future and the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with standard models of rational choice, since the rate of discount between time t'' and ''t+1 will be low at time t-1, when t'' is the near future, but high at time ''t when t'' is the present and time ''t+1 the near future. frame|Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel winner [[Daniel Kahneman, was an important figure in the development of behavioral finance and economics and continues to write extensively in the field.]] Methodology At the outset behavioral economics and finance theories were developed almost exclusively from experimental observations and survey responses, though in more recent times real world data has taken a more prominent position. fMRI has also been used to determine which areas of the brain are active during various steps of economic decision making. Experiments simulating market situations such as stock market trading and auctions are seen as particularly useful as they can be used to isolate the effect of a particular bias upon behavior; observed market behavior can typically be explained in a number of ways, carefully designed experiments can help narrow the range of plausible explanations. Experiments are designed to be incentive compatible, with binding transactions involving real money the norm. Key observations There are three main themes in behavioral finance and economics (Shefrin, 2002): *Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analyses. See also cognitive biases and bounded rationality. *Framing: The way a problem or decision is presented to the decision maker will affect their action. *Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has written a long series of papers describing specific market anomalies from a behavioral perspective. Market wide anomalies cannot generally be explained by individuals suffering from cognitive biases, as individual biases often do not have a large enough effect to change market prices and returns. In addition, individual biases could potentially cancel each other out. Cognitive biases have real anomalous effects only if there is a social contamination with a strong emotional content (collective greed or fear), leading to more widespread phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology as on individual psychology. There are two exceptions to this general statement. First, it might be the case that enough individuals exhibit biased (ie. different from rational expectations) behavior that such behavior is the norm and this behavior would, then, have market wide effects. Further, some behavioral models explicitly demonstrate that a small but significant anomalous group can have market-wide effects (eg. Fehr and Schmidt, 1999). Issues in behavioral economics Behavioral finance The central issue in behavioral finance is explaining why market participants make systematic errors. Such errors affect prices and returns, creating market inefficiencies. It also investigates how other participants take advantage (arbitrage) of such market inefficiencies. Behavioral finance highlights inefficiencies such as under- or over-reactions to information as causes of market trends (and in extreme cases of bubbles and crashes). Such reactions have been attributed to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise trading. Technical analysts consider behavioral finance, behavioral economics' academic cousin, to be the theoretical basis for technical analysis. Other key observations include the asymmetry between decisions to acquire or keep resources, known as the "bird in the bush" paradox, and loss aversion, the unwillingness to let go of a valued possession. Loss aversion appears to manifest itself in investor behavior as a reluctance to sell shares or other equity, if doing so would result in a nominal loss. Genesove & Mayer, 2001 It may also help explain why housing prices rarely/slowly decline to market clearing levels during periods of low demand. Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity premium puzzle, something conventional finance models have been unable to do so far. Experimental finance applies the experimental method, e.g., creating an artificial market by some kind of simulation software to study people's decision-making process and behavior in financial markets. Quantitative behavioral finance Quantitative behavioral finance uses mathematical and statistical methodology to understand behavioral biases. In marketing research, a study shows little evidence that escalating biases impact marketing decisions. Leading contributors include Gunduz Caginalp (Editor of the Journal of Behavioral Finance from 2001–2004) and collaborators including 2002 Nobelist Vernon Smith, David Porter, Don Balenovich, Vladimira Ilieva and Ahmet Duran, and Ray Sturm. Financial models Some financial models used in money management and asset valuation incorporate behavioral finance parameters, for example: * Thaler's model of price reactions to information, with three phases, underreaction-adjustment-overreaction, creating a price trend :One characteristic of overreaction is that average returns following announcements of good news is lower than following bad news. In other words, overreaction occurs if the market reacts too strongly or for too long to news, thus requiring adjustment in the opposite direction. As a result, outperforming assets in one period are likely to underperform in the following period. This also applies to customers' irrational purchasing habits. * The stock image coefficient Criticisms Critics such as Eugene Fama typically support the efficient-market hypothesis. They contend that behavioral finance is more a collection of anomalies than a true branch of finance and that these anomalies are either quickly priced out of the market or explained by appealing to market microstructure arguments. However, individual cognitive biases are distinct from social biases; the former can be averaged out by the market, while the other can create positive feedback loops that drive the market further and further from a "fair price" equilibrium. Similarly, for an anomaly to violate market efficiency, an investor must be able to trade against it and earn abnormal profits; this is not the case for many anomalies.Fama on Market Efficiency in a Volatile Market A specific example of this criticism appears in some explanations of the equity premium puzzle. It is argued that the cause is entry barriers (both practical and psychological) and that returns between stocks and bonds should equalize as electronic resources open up the stock market to more traders.See Freeman, 2004 for a review In reply, others contend that most personal investment funds are managed through superannuation funds, minimizing the effect of these putative entry barriers. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials. Behavioral game theory Behavioral game theory is a subject that analyzes interactive strategic decisions and behavior using the methods of game theory,R. J. Aumann (2008). "game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. experimental economics, and experimental psychology. Experiments include testing deviations from typical simplifications of economic theory such as the independence axiomColin F. Camerer and Teck-Hua Ho (1994). "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and Uncertainty, 8(2), pp. 167–196. and neglect of altruism,James Andreoni et al. (2008). "altruism in experiments," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. fairness,H. Peyton Young (2008). "social norms," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. and framing effects.Colin F. Camerer (1997). "Progress in Behavioral Game Theory," Journal of Economic Perspectives, 11(4), p. 172 [http://authors.library.caltech.edu/22122/1/2138470%5B1%5D.pdf 167–188. On the positive side, the method has been applied to interactive learning* William H. Sandholm (2008). "learning and evolution in games: an overview," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. * Teck H. Ho (2008). "Individual learning in games," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. and social preferences.Martin Dufwenberg and Georg Kirchsteiger (2004). "A Theory of Sequential reciprocity," Games and Economic Behavior, 47(2), pp. 268–298. Abstract.* Faruk Gul (2008). "behavioural economics and game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. * Colin F. Camerer (2008). "behavioral game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. As a research program, the subject is a development of the last three decades.• Colin F. Camerer (2003). Behavioral Game Theory, Princeton. Description, preview (ctrl+), and ch. 1 link. * _____, George Loewenstein, and Matthew Rabin, ed. (2003). Advances in Behavioral Economics, Princeton. 1986–2003 papers. Description, contents, and preview. * Drew Fudenberg (2006). "Advancing Beyond Advances in Behavioral Economics," Journal of Economic Literature, 44(3), pp. 694–711. * Vincent P. Crawford (1997). "Theory and Experiment in the Analysis of Strategic Interaction," in Advances in Economics and Econometrics: Theory and Applications, pp. 206–242. Cambridge. Reprinted in Camerer et al. (2003), Advances in Behavioral Economics, Princeton, ch. 12. * Martin Shubik (2002). "Game Theory and Experimental Gaming," in R. Aumann and S. Hart, ed., Handbook of Game Theory with Economic Applications, Elsevier, v. 3, pp. 2327–2351. Abstract. • Charles R. Plott and Vernon L. Smith, ed. (2008). Handbook of Experimental Economics Results, v. 1, Elsevier, Part 4, Games preview and ch. 45–66 preview links. * Games and Economic Behavior, Elsevier. Aims and scope and, article-preview links by year and issue. Economic reasoning in non-human animals A handful of comparative psychologists have attempted to demonstrate economic reasoning in non-human animals. Early attempts along these lines focus on the behavior of rats and pigeons. These studies draw on the tenets of behavioral psychology, where the main goal is to discover analogs to human behavior in experimentally-tractable non-human animals. They are also methodologically similar to the work of Ferster and Skinner.Ferster, C.B. et al. (1957). Schedules of Reinforcement. New York: Appleton-Century-Crofts. Methodological similarities aside, early researchers in non-human economics deviate from behaviorism in their terminology. Although such studies are set up primarily in an operant conditioning chamber, using food rewards for pecking/bar-pressing behavior, the researchers describe pecking and bar pressing not in terms of reinforcement and stimulus–response relationships, but instead in terms of work, demand, budget, and labor. Recent studies have adopted a slightly different approach, taking a more evolutionary perspective, comparing economic behavior of humans to a species of non-human primate, the capuchin monkey.Chen, M.K. et al. (2006). How basic are behavioral biases? Evidence from capuchin monkey trading behavior. J. Political Economy, 114 (3) 517–537. The animal as a human analog Many early studies of non-human economic reasoning were performed on rats and pigeons in an operant conditioning chamber. These studies looked at things like peck rate (in the case of the pigeon) and bar-pressing rate (in the case of the rat) given certain conditions of reward. Early researchers claim, for example, that response pattern (pecking/bar pressing rate) is an appropriate analog to human labor supply.Battalio, R.C. et al. (1981). Income–leisure tradeoffs of animal workers. Am. Economic Review, 71 (4) 621–632. Researchers in this field advocate for the appropriateness of using animal economic behavior to understand the elementary components of human economic behavior.Kagel, J H. et al. (1995). Economic Choice Theory: An Experimental Analysis of Animal Behavior. New York: Cambridge University Press Syndicate. In a paper by Battalio, Green, and Kagel (1981, p 621), they write Labor supply The typical laboratory environment to study labor supply in pigeons is set up as follows. Pigeons are first deprived of food. Since the animals are hungry, food becomes highly desired. The pigeons are placed in an operant conditioning chamber and through orienting and exploring the environment of the chamber they discover that by pecking a small disk located on one side of the chamber, food is delivered to them. In effect, pecking behavior becomes reinforced, as it is associated with food. Before long, the pigeon pecks at the disk (or stimulus) regularly. In this circumstance, the pigeon is said to "work" for the food by pecking. The food, then, is thought of as the currency. The value of the currency can be adjusted in several ways, including the amount of food delivered, the rate of food delivery and the type of food delivered (some foods are more desirable than others). Economic behavior similar to that observed in humans is discovered when the hungry pigeons stop working/work less when the reward is reduced. Researchers argue that this is similar to labor supply behavior in humans. That is like humans (who, even in need, will only work so much for a given wage) the pigeons demonstrate decreases in pecking (work) when the reward (value) is reduced. Demand In human economics, a typical demand curve is negative. This means that as the price of a certain good increases, the amount that consumers are able to purchase decreases. Researchers studying demand curves in non-human animals such as rats observe that demand curves have negative slopes, consistent with the slope of human demand curves. Researchers have studied demand in rats in a manner distinct from studying labor supply in pigeons. Specifically, say we have experimental subjects, rats, in an operant chamber and we require them to press a lever to receive a reward. The reward can be either food (reward pellets), water, or a commodity drink such as cherry cola. Unlike previous pigeon studies, where the work analog was pecking and the monetary analog was reward, in the studies on demand in rats, the monetary analog is bar pressing. Under these circumstances, the researchers claim that changing the number of bar presses required to obtain a commodity item is analogous to changing the price of a commodity item in human economics.Kagel, J.H. et al. (1981). Demand curves for animal consumers. Quarterly Journal of Economics, 96 (1), 1–16. In effect, results of demand studies in non-human animals are that, as the bar-pressing requirement (cost) increases, the animal presses the bar the required number of times less often (payment). Monkey trading behavior Recent work on economic behavior in non-human animals has focused on capuchin monkeys. Here the researchers seem less inclined toward the behaviorist tradition of the laboratory animal-human behavior analog. Instead, they attempt to adopt a more evolutionary perspective, positing that economic reasoning might be basic, unlearned, and serve some adaptive function. One recent study involves the introduction of a currency system into a colony of captive capuchin monkeys. The currency is in the form of coins and is redeemable for food and other purchasable items when exchanged with a researcher. Under these conditions, the researchers studied three features of monkey trading: demand, loss aversion, and risk aversion. In this study, monkeys are presented with an amount of money and are shown a certain amount of food or other goods. The monkeys must take the money and hand it to the experimenter in exchange for goods. In one condition of the experiment, after the monkey has paid for the goods, it has the option to take a sure amount of food now, or wait until the experimenter alters the amount of food presented. In this circumstance, the experimenter can either increase or decrease the amount of food given. Thus, this experimental setup allows the researchers to look at the gambling behavior of the animals. The experimenters can therefore ask the following questions: will the monkey take the sure amount of food? Will the monkey “gamble” by waiting until the experimenter changes the amount of food present? Does the decision of the animal depend on the circumstances? Results indicate that the monkeys are risk-averse: they prefer to take the initial amount of food than wait for the experimenter to change the amount presented. The experimenters introduce several other manipulations, including changing the allocated budget, changing the cost of certain items, changing the items themselves. Specifically, the researchers found an increase in item purchase and consumption when that item decreases in value, a result consistent with those found in human economics. Taken together, the results of this study indicate that capuchin monkeys are not only risk-averse, but are also sensitive to constructs such as price, budget, and payoff expectation. According to the researchers, the animals are not trained to behave in this way; these behaviors arise naturally in the trading environment. As a result, these researchers argue that basic economic behavior and reasoning might be unlearned, innate, and subject to natural selection. Behavioral finance models Some financial models used in money management and asset valuation use behavioral finance parameters, for example * Thaler's model of price reactions to information, with three phases, underreaction - adjustment - overreaction, creating a price trend The characteristic of overreaction is that the average return of asset prices following a series of annnouncemnts of good news is lower than the average return following a series of bad announcements. In other words, overreaction occurs if the market reacts to strong to news that it subsequently needs to be compensated in the opposite direction. As a result, assets that were winners in the past should not be seen as an indication to invest in as their risk adusted returns in the future are relatively low compared to stocks that were defined as losers in the past. * The stock image coefficient Criticisms of behavioral finance Critics of behavioral finance, such as Eugene Fama, typically support the efficient market theory. They contend that behavioral finance is more a collection of anomalies than a true branch of finance and that these anomalies will eventually be priced out of the market or explained by appeal to market microstructure arguments. However, a distinction should be noted between individual biases and social biases; the former can be averaged out by the market, while the other can create feedback loops that drive the market further and further from the equilibrium of the "fair price". A specific example of this criticism is found in some attempted explanations of the equity premium puzzle. It is argued that the puzzle simply arises due to entry barriers (both practical and psychological) which have traditionally impeded entry by individuals into the stock market, and that returns between stocks and bonds should stabilize as electronic resources open up the stock market to a greater number of traders (See Freeman, 2004 for a review). In reply, others contend that most personal investment funds are managed through superannuation funds, so the effect of these putative barriers to entry would be minimal. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials. Behavioral economics topics Models in behavioral economics are typically addressed to a particular observed market anomaly and modify standard neo-classical models by describing decision makers as using heuristics and being affected by framing effects. In general, behavioural economics sits within the neoclassical framework, though the standard assumption of rational behaviour is often challenged. Heuristics Prospect theory - Loss aversion - Status quo bias - Gambler's fallacy - Self-serving bias Framing Cognitive framing - Mental accounting - Reference utility - Anchoring Anomalies Disposition effect - Endowment effect - Equity premium puzzle - Money illusion - Dividend puzzle -Fairness (Inequity aversion) - Efficiency wage hypothesis - Reciprocity - Intertemporal consumption - Present biased preferences - Behavioral life cycle hypothesis - Wage stickiness - Price stickiness - Visceral influences - Earle's Curve of Predictive Reliability - Limits to Arbitrage - Income and happiness - momentum investing Evolutionary psychology An evolutionary psychology perspective is that many of the seeming limitations in rational choice can be explained as being rational in the context of maximizing biological fitness in the ancestral environment but not necessarily in the current one. Thus, when living at subsistence level where a reduction of resources may have meant death it may have been rational to place a greater value on losses than on gains. It may also explain differences between groups such as males being less risk-averse than females since males have more variable reproductive success than females. While unsuccessful risk-seeking may limit reproductive success for both sexes, males may potentially increase their reproductive success much more than females from successful risk-seeking.Paul H. Rubin and C. Monica Capra. The evolutionary psychology of economics. In History During the classical period, microeconomics was closely linked to psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, which proposed psychological explanations of individual behavior, including concerns about fairness and justice,Nava Ashraf, Colin F. Camerer, and George Loewenstein (2005). "Adam Smith, Behavioral Economist," Journal of Economic Perspectives, 19(3), p. 142. [http://webserver1.pugetsound.edu/facultypages/gmilam/courses/econ291/readings/ASmithBenEcon.pdf 131–145. and Jeremy Bentham wrote extensively on the psychological underpinnings of utility. However, during the development of neo-classical economics economists sought to reshape the discipline as a natural science, deducing economic behavior from assumptions about the nature of economic agents. They developed the concept of homo economicus, whose psychology was fundamentally rational. This led to unintended and unforeseen errors. However, many important neo-classical economists employed more sophisticated psychological explanations, including Francis Edgeworth, Vilfredo Pareto and Irving Fisher. Economic psychology emerged in the 20th century in the works of Gabriel Tarde,Tarde, G. Psychologie économique (1902), George KatonaThe Powerful Consumer: Psychological Studies of the American Economy. 1960. and Laszlo Garai.Garai,L. Identity Economics – An Alternative Economic Psychology. 1990–2006. Expected utility and discounted utility models began to gain acceptance, generating testable hypotheses about decision making given uncertainty and intertemporal consumption respectively. Observed and repeatable anomalies eventually challenged those hypotheses, and further steps were taken by the Nobel prizewinner Maurice Allais, for example in setting out the Allais paradox, a decision problem he first presented in 1953 which contradicts the expected utility hypothesis. , winner of 2002 Nobel prize in economics.]] In the 1960s cognitive psychology began to shed more light on the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field, such as Ward Edwards, Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. In mathematical psychology, there is a longstanding interest in the transitivity of preference and what kind of measurement scale utility constitutes (Luce, 2000). Prospect theory In 1979, Kahneman and Tversky wrote Prospect theory: An Analysis of Decision Under Risk, an important paper that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory. Prospect theory has two stages, an editing stage and an evaluation stage. In the editing stage, risky situations are simplified using various heuristics of choice. In the evaluation phase, risky alternatives are evaluated using various psychological principles that include the following: * (1) Reference dependence: When evaluating outcomes, the decision maker has in mind a "reference level". Outcomes are then compared to the reference point and classified as "gains" if greater than the reference point and "losses" if less than the reference point. * (2) Loss aversion: Losses bite more than equivalent gains. In their 1979 paper in Econometrica, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i.e., losses bite about 2.25 time more than equivalent gains. * (3) Non-Linear probability weighting: Evidence indicates that decision makers overweight small probabilities and underweight large probabilities – this gives rise to the inverse-S shaped "probability weighting function". * (4) Diminishing sensitivity to gains and losses: As the size of the gains and losses relative to the reference point increase in absolute value, the marginal effect on the decision maker's utility or satisfaction falls. Prospect theory is able to explain everything that the two main existing decision theories – expected utility theory and rank dependent utility – can explain. However, the converse is false. Prospect theory has been used to explain a range of phenomena that existing decision theories have great difficulty in explaining. These include backward bending labour supply curves, asymmetric price elasticities, tax evasion, co-movement of stock prices and consumption etc. In 1992, in the Journal of Risk and Uncertainty, Kahneman and Tversky gave their revised account of prospect theory that they called cumulative prospect theory. The new theory eliminated the editing phase in prospect theory and focused just on the evaluation phase. Its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in John Quiggin's rank dependent utility theory. Psychological traits such as overconfidence, projection bias, and the effects of limited attention are now part of the theory. Other developments include a conference at the University of Chicago, a special behavioral economics edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') and Kahneman's 2002 Nobel for having "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty". Intertemporal choice Behavioral economics has also been applied to intertemporal choice. Intertemporal choice behavior is largely inconsistent, as exemplified by George Ainslie's hyperbolic discounting (1975) which is one of the prominently studied observations, further developed by David Laibson, Ted O'Donoghue, and Matthew Rabin. Hyperbolic discounting describes the tendency to discount outcomes in near future more than for outcomes in the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with basic models of rational choice, since the rate of discount between time t'' and ''t+1 will be low at time t-1, when t'' is the near future, but high at time ''t when t'' is the present and time ''t+1 the near future. The pattern can actually be explained through models of subadditive discounting which distinguishes the delay and interval of discounting: people are less patient (per-time-unit) over shorter intervals regardless of when they occur. Much of the recent work on intertemporal choice indicates that discounting is a constructed preference. Discounting is influenced greatly by expectations, framing, focus, thought listings, mood, sign, glucose levels, and the scales used to describe what is discounted. Some prominent researchers question whether discounting, the major parameter of intertemporal choice, actually describes what people do when they make choices with future consequences. Considering the variability of discount rates, this may be the case. Other areas of research Other branches of behavioral economics enrich the model of the utility function without implying inconsistency in preferences. Ernst Fehr, Armin Falk, and Matthew Rabin studied "fairness", "inequity aversion", and "reciprocal altruism", weakening the neoclassical assumption of "perfect selfishness." This work is particularly applicable to wage setting. Work on "intrinsic motivation" by Gneezy and Rustichini and on "identity" by Akerlof and Kranton assumes agents derive utility from adopting personal and social norms in addition to conditional expected utility. "Conditional expected utility" is a form of reasoning where the individual has an illusion of control, and calculates the probabilities of external events and hence utility as a function of their own action, even when they have no causal ability to affect those external events. Behavioral economics caught on among the general public, with the success of books like Dan Ariely's Predictably Irrational. Practitioners of the discipline have studied quasi-public policy topics such as broadband mapping. Criticisms of behavioral economics Critics of behavioral economics typically stress the rationality of economic agents (see Myagkov and Plott (1997) amongst others). They contend that experimentally observed behavior is inapplicable to market situations, as learning opportunities and competition will ensure at least a close approximation of rational behavior. Others note that cognitive theories, such as prospect theory, are models of decision making, not generalized economic behavior, and are only applicable to the sort of once-off decision problems presented to experiment participants or survey respondents. Traditional economists are also skeptical of the experimental and survey based techniques which are used extensively in behavioral economics. Economists typically stress revealed preferences, over stated preferences (from surveys) in the determination of economic value. Experiments and surveys must be designed carefully to avoid systemic biases, strategic behavior and lack of incentive compatibility and many economists are distrustful of results obtained in this manner due to the difficulty of eliminating these problems. Rabin (1998) dismisses these criticisms, claiming that results are typically reproduced in various situations and countries and can lead to good theoretical insight. Other proponents of behavioral economics note that neoclassical models often fail to predict outcomes in real world contexts. Behavioral insights can be used to update neoclassical equations, and behavioral economists note that these revised models not only reach the same correct predictions as the traditional models, but also correctly predict outcomes where the traditional models failed. Rabin (1998) dismisses these criticisms, claiming that consistent results are typically obtained in multiple situations and geographies and can produce good theoretical insight. Behavioral economists have also responded to these criticisms by focusing on field studies rather than lab experiments. Some economists see a fundamental schism between experimental economics and behavioral economics, but prominent behavioral and experimental economists tend to share techniques and approaches in answering common questions. For example, behavioral economists are actively investigating neuroeconomics, which is entirely experimental and cannot yet be verified in the field. Other proponents of behavioral economics note that neoclassical models often fail to predict outcomes in real world contexts. Behavioral insights can influence neoclassical models. Behavioral economists note that these revised models not only reach the same correct predictions as the traditional models, but also correctly predict some outcomes where the traditional models failed. Key figures George Akerlof - Dan Ariely - Colin Camerer - Ernst Fehr - Daniel Kahneman - Werner Güth - David Laibson - George Loewenstein - Sarah Lichtenstein - Lola Lopes Matthew Rabin - Robert Shiller - Richard Thaler - Amos Tversky - Paul Slovic - Andrei Shleifer - Hersh Shefrin - Werner De Bondt Non-specialists whose work is important to the field Herbert Simon - Gerd Gigerenzer - Fischer Black - John Tooby - Leda Cosmides - Paul Rubin - Donald Rubin - Ronald Coase See also * Adaptive market hypothesis * Behavioralism * Behavioral finance * Behavioral operations research * Cognitive bias * Cognitive psychology * Confirmation bias * Cultural economics * Culture change * Culture speculation * Economic sociology * Emotional bias * Experimental economics * Experimental finance * Fuzzy-trace theory * Habit (psychology) * Hindsight bias * Homo economicus * Important publications in behavioral finance(economics) * Journal of Behavioral Finance * List of cognitive biases * Methodological individualism * Neuroeconomics * Observational techniques * Praxeology * Rationality * Repugnancy costs * Socioeconomics * Socionomics References * Kahneman, D. & Tversky, A. 'Prospect Theory: An Analysis of Decision under Risk,' Econometrica, XVLII (1979), 263–291 * Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford Universtity Press * Camerer, C. F.; Loewenstein, G. & Rabin, R. (eds.) (2003) Advances in Behavioral Economics * Shleifer, Andrei (1999) Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press * Shlomo Benartzi; Richard H. Thaler 'Myopic Loss Aversion and the Equity Premium Puzzle' (1995) The Quarterly Journal of Economics, Vol. 110, No. 1. * Matthew Rabin 'Psychology and Economics,' Journal of Economic Literature, American Economic Association, vol. 36(1), pages 11-46, March 1998. Further reading * Henrich, J., Boyd, R., Bowles S., Camerer C., Fehr E., Gintis H., McElreath R., Alvard M., Barr A., Ensminger J., Hill K., Gil-White F., Gurven M., Marlowe F., Patton J.Q., Smith N., and Tracer D. (2005). "Economic Man" in Cross-cultural Perspective: Behavioral Experiments in 15 Small-scale Societies, Behavioral and Brain Sciences, 28, 795–855. Full text * Rogers, A. R. (1997) Evolution and Human Choice over Time. In G. Bock & G. Cardew (Eds.), Characterizing Human Psychological Adaptations, CIBA Symposium 208, John Wiley and Sons, pp. 231-252. Full text External links *Universiteit Amsterdam; Center for Experimental Economics and Political Decision Making *Behavioural Finance *Behavioral Finance Initiative of the International Center for Finance at the Yale School of Management *Behavioral-Finance Group FAQ / Glossary *History of Behavioral finance *Richard Thaler's 'anomalies' papers *Behavioural Finance at MoneyScience *Born Suckers - The greatest Wall Street danger of all: you. By ... - Dec. 14, 2004 *"On the Robustness of Behavioral Economics" - an academic analysis in the Yale Economic Review *The Marketplace of Perceptions *Behavioral Finance-Theory and Practical Application *Integrating Traditional and Behavioral Finance *Olivier Brandouy's Experimental finance Page * JessX(java experimental simulated stock exchange), simulation software for Experimental finance Category:social psychology Category:Economics Category:Finance